Recent SEC Administrative Proceeding Against Hedge Fund Adviser Illustrates
Classic Application of Integration Principles and Limitations on Private
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On July 8, 2005, the U.S. Securities and Exchange Commission issued an
Order instituting and settling an administrative proceeding against a hedge
fund investment adviser.1
The proceeding demonstrates the increased focus of the SEC on hedge fund
advisers and the hedge fund industry. Given the continued interest of Greenberg
Traurig’s clients and prospective clients in investment fund activities,
we prepared this GT Alert as a cautionary summary of what is a current “hot
topic” at the SEC.
|“The proceeding demonstrates
the increased focus of the SEC on hedge fund advisers and the hedge
One factor that makes this case interesting is that there was no assertion
of any actual harm or of any specific loss to an investor, issues usually
present in such proceedings. While the alleged violations are significant
in legal terms, our sense is that the case involves actions that were not
driven by corrupt intentions as much as business decisions that did not
comply with legal restrictions. The core of the findings is that the respondents:
- by selling to 64 non-accredited investors in multiple entities that
were integrated into one entity, violated the registration requirements
for offering and sale of securities under the Securities Act of 1933,
- by disseminating information about the private offering over the airwaves
and the internet, cannot then claim to be conducting a private offering
under the Securities Act of 1933, and
- by failing to qualify for the exemption in Section 3(c)(1) of the
Investment Company Act of 1940 limiting the number of investors to not
more than one hundred, violated the prohibition on sales of shares in
an unregistered investment company.
A summary of the allegations is that the respondents established a hedge
fund in 2000 to serve as the investment vehicle for potential clients who
would not qualify to open individual accounts since they had assets that
were below the minimum account level for the adviser. In 2002 the respondents
established a second hedge fund. Though some differences were asserted by
the respondents regarding the investment strategies of the two funds, the
SEC found that the operations of the funds and the composition of their
portfolios did not demonstrate any material differences that constituted
a bona fide business basis for maintaining multiple entities. For
this reason the SEC integrated the two funds, and integrated
the two separate private offerings that offered and sold the interests in
the two funds.
As we have so often noted, many hedge funds remain free of registration
as investment companies under the 1940 Act by relying on the exemption provided
by Section 3(c)(1). That paragraph requires that the exempt fund (i) is
not conducting a public offering, and (ii) does not have more than 100 beneficial
owners. To satisfy the first criteria, hedge funds typically rely on Regulation
D to conduct private offerings, and therefore may not sell to more than
35 non-accredited investors. To comply with the second requirement, a hedge
fund must cease the distribution of its interests at a level below 100 beneficial
In this case, the SEC alleged violations of both limitations. The SEC
found that when the offerings were integrated, aggregate sales were made
to 64 non-accredited investors. This cost the hedge fund its exemption under
Regulation D. For this reason the SEC held that the issuer had sold securities
in a public offering and they were not registered as required by Section
5 of the 1933 Act. Thus, the offering violated Section 5 of the 1933 Act.
The loss of the private offering exemption also meant that the integrated
fund had not complied with the “no-public-offering” requirement of section
3(c)(1). In addition, the SEC found that when the entities are integrated,
there are a total of 112 investors, and that meant that the fund had not
met the second prong of section 3(c)(1), the less than one hundred person
test. Without the exemption provided by Section 3(c)(1), the entity was
an investment company required to be registered, and the failure to do so
(and the subsequent failure to comply with the provisions of the 1940 Act)
was a further violation.
Recognizing what appears to be the absence of a venal intent, the SEC
limited its monetary sanction to a $20,000 fine, hardly massive by today’s
standards, and then threw in a censure. Oh yes, they also added a cease
and desist order. Now the respondents are facing years of “bad boy” disqualification
from registrations and exemptions under most state blue sky laws, and under
many aspects of the federal securities laws.
One interesting question raised by this case is “what led the SEC to
pursue it in the first instance if no one was hurt and presumably no one
was complaining?” Remember the attempt to qualify for the private offering
exemption? Well, the SEC’s Order notes that the sponsors mentioned the offerings
during radio interviews, and posted information regarding this project on
their web site. The SEC viewed that as somewhat incompatible with a claim
that there is no public offering under way. Perhaps the SEC staff was troubled
by having their collective nose “rubbed” in what was going on. The terms
of the consent Order specifically refer to the objectionable public dissemination
of information about the securities.
In any event, we have been cautioning clients that hedge funds and the
exemptions upon which they rely are a current hot issue at the SEC, and
that the SEC is clearly pulling in the reins. We just want to take this
opportunity to renew our caution to our colleagues and clients to exercise
care when moving ahead into these activities.
1 In the Matter of Gerald Klein & Associates,
Inc. and Klein Pavlis & Peasley Financial, Inc., 1933 Act Release No.
8595, 1940 Act Release No. 26986, July 8, 2005.
This Alert was written
Terrance J. Reilly and
Steven M. Felsenstein in
the Philadelphia office. Please contact Mr. Reilly at 215.988.7815, Mr.
Felsenstein at 215.988.7837, or your Greenberg Traurig liaison, if you have
any questions regarding the subject matter of this Alert.
© 2005 Greenberg Traurig
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